Forget the hype around Buffett – you’ll be better off in a tracker fund

Warren Buffett's story is the stuff of investment fairy tales.

He went from managing a small amount of money in his bedroom in Omaha, to being one of the world's richest men. So it's no surprise that his investment vehicle, Berkshire Hathaway (NYSE: BRK.A) is so closely watched.

Now people are tying themselves in knots trying to figure out Berkshire's latest big deal. It is planning to spend $12-$13 billion to buy up half of one of the world's most iconic food brands - Heinz.

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The deal looks expensive, unusual for someone like Buffett, who is seen as a value' investor. Some argue that it just shows that big, brand-name companies are worth paying up for, even now.

But that's the wrong conclusion to draw. The truth is, this deal is just yet more proof that Buffett's deals today have very little in common with the deals that made him an investment legend.

And it also suggests that you'd be better off with an index-tracking fund than with shares in Berkshire in the years ahead.

Here's why...

Warren Buffett has given up value investing

Warren Buffett was unquestionably one of the world's greatest ever value investors. Starting out in the mid-1950s, he practised 'cigar butt' investing: buying distressed, hated companies that were selling for a fraction of what they were really worth. Over the last 57 years, his investment gains have snowballed into the conglomerate that is now Berkshire Hathaway.

No doubt Buffett and Berkshire would love to keep buying these types of companies. But this is no longer possible. For one thing, there are very few cheap 'cigar butt'-type investments out there right now. For another, even if he did find some, Berkshire's vast size ($424bn of assets) means that the individual deals would not make much of a difference to the company's fortunes.

These days, Berkshire has to spend large amounts of money buying stakes in market-leading giants with steady, predictable profits. We're talking aboutthe likes of Tesco, IBM and Coca-Cola here. These sorts of companies are meant to keep Berkshire's profits and asset value growing in the years ahead.

But while they might be big players, they still follow classic Buffett rules: they're easy to understand, and they have 'big moats' rivals find it hard to compete with them, and they hold a lot of pricing power in their markets. For many years now, Buffett has told investors to buy the shares of these companies if they are on sale for a fair price.

You can see why Heinz is seen by many as a classic Buffett investment. It owns a huge range of brands and should have more than enough pricing power to keep growing its profits over the long haul.

There's just one catch. On the face of it, Buffett is hardly getting good value with this deal. Indeed, in paying $72.50 per share for Heinz, Buffett and his private equity partner, 3G, are paying a hefty price for a business that isn't growing that much - over 20 times 2013 forecast earnings.

Or at least, that's how it looks until you look under the bonnet of the deal.

You cannot copy Buffett

Don't be fooled into thinking that Buffett's swoop on Heinz means you should be piling into consumer goods shares at current prices. This deal is much more about clever financial engineering than any sort of great equity growth story. In fact, the way this deal is structured suggests that Buffett wants to ensure that he is exposed to less risk than normal shareholders.

Here's why. Most of Buffett's investment and return is coming in the form of preference shares ($9bn of them with another $4bn of equity on top). Preference share dividends get paid out before ordinary dividends. So this means Buffett has first claim on the company's post-tax profits. These preference shares are rumoured to be paying him a very juicy annual return of 9% or $810m.

When you think that Heinz's post-tax income is expected to be around $1.1bn in 2013, that's a nice chunk of the profits for Buffett. But the thing is Heinz is being loaded up with debt - around $20bn of it (including the preference shares) compared with $5bn now.

This means that Heinz's after-tax profits are likely to fall (as its interest payments shoot up). So Buffett could be taking virtually all of the income, with 3G getting next to nothing in the early years. My guess is that Heinz is going to have to generate a lot more cash than it does now for 3G to be laughing all the way to the bank.

Buffett, on the other hand, will get a virtually guaranteed $810m every year, and a chance of his equity stake going up in value if everything works out.

Sadly, private investors can't get the same sort of cosy deals that Buffett's wealth and influence bring him. Like his investments in Goldman Sachs and Bank of America in recent times, Buffett has been able to get good, fixed returns with less risk than being an ordinary shareholder.

The fact is that for all his professed faith in the future of the US economy, Buffett doesn't like these companies enough to be last in the queue to get paid, despite describing them as great businesses.

It's a case of do as I say, not as I do'.

A tracker fund may be a better bet than Berkshire Hathaway shares

The Heinz deal highlights a major problem for both investors in Berkshire Hathaway and investors in general. This is that future returns from most assets are likely to be modest at best.

Berkshire is a big lumbering giant of a company. Even a 9% return from Heinz preference shares isn't going to move the dial at Berkshire much, given its vast size. And as the chart below shows, even with Buffett's undoubted deal-making skills, Berkshire has lagged the returns of the S&P 500 (Berkshire's share price is in red, the S&P 500 in blue).

And who knows if Buffett's successor will have the clout to be able to do the same sort of deals in the future? So those wanting to bet on the future of big American businesses might be better off with an index-tracking fund rather than shares in Berkshire. At least you won't have to worry about succession issues then.

Alternatively, if you're interested in the sorts of deals that private equity groups make, in this week's MoneyWeek magazine, David C Stevenson looks at some of the best ways to invest in the sector. (If you're not already a subscriber, you can subscribe to MoneyWeek magazine.)

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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